Fed's rate cuts may do long-term dollar damage

By Steven C. Johnson - Analysis

NEW YORK (Reuters) - By many measures, confidence in the dollar has never been lower, and some fear more Federal Reserve interest rate cuts will make matters worse by swelling inflation and undermining long-term U.S. economic health.

The Fed has cut benchmark interest rates from 5.25 percent to 3 percent since September, and the central bank's Chairman Ben Bernanke has signaled he would reduce them further to boost an economy that many on Wall Street and beyond fear is already in recession.

That's pushed the dollar to an all-time low against a basket of currencies and the euro to $1.5275 for the first time in its nine-year history. The Fed's own broad trade-weighted dollar index fell to a 12-year low.

But whether the central bank succeeds in forestalling recession is of little consequence to dollar investors these days. The most optimistic forecasts call for little more than anemic growth even if the Fed succeeds.

More troubling is the fear that whatever success the central bank achieves will have been bought at the expense of future inflation, shattering confidence in the dollar.

A weakening dollar increases the cost of imported goods for Americans and tends to perpetuate rising oil prices because it makes energy cheaper for non-U.S. consumers, prompting more consumption.

"It's a worry, because I think the dollar weakness we're seeing stems from the perception that the Fed and other central banks have different policy priorities," said Merrill Lynch currency strategist Steven Englander.

"With the euro above $1.50, it wouldn't surprise me if investors were concerned about where the dollar was headed."

The Fed's rush to cut interest rates contrasts with the European Central Bank's approach, which has been to hold rates at 4 percent to fight uncomfortably high inflation.

It's also at odds with central banks in Australia and the emerging markets that have recently raised rates.

That has erased the dollar's yield advantage against the euro and other major currencies, sending it sharply lower.

Englander said the Fed hopes pro-growth measures will help the dollar later. "The goal is not a strong dollar a month from now but a stronger dollar two years from now."

A BOTTOMLESS PIT

But some investors worry that it can be hard to get the inflation genie back in the bottle once he's escaped. In the 1970s, it took a massive tightening campaign that pushed rates past 16 percent before the Fed regained control.

Underlying U.S. consumer inflation is running at 2.47 percent in the 12 months to January, the highest since February 2007. Investors have poured into commodities as a hedge against inflation, sending oil to a record above $103 a barrel and gold near $1,000 an ounce.